Incentive effects of executive compensation and the valuation of firm assets

This paper examines how executive compensation influences the market value of the firm's assets. After controlling for endogeneity, we find that boards have set the incentive to incur risk (vega) to maximize shareholder value, but that incentives to increase returns (delta) do not maximize shareholder value. We also find that current levels of cash compensation do not maximize shareholder value. Finally, we consider the moneyness of stock options. We find that the level of at- and out-of-the money options maximize shareholder value, but the level of in-the money options do not maximize shareholder value.     

Ironing out the kinks in executive compensation: Linking incentive pay to average stock prices

Traditional stock option grant is the most common form of incentive pay in executive compensation. Applying a principal-agent analysis, we find this common practice suboptimal and firms are better off linking incentive pay to average stock prices. Among other benefits, averaging reduces volatility by about 42%, making the incentive pay more attractive to risk-averse executives. Holding the cost of the option grant to the firm constant, Asian stock options are more cost effective than traditional stock options and provide stronger incentives to increase stock price. More importantly, the improvement is achieved with little impact on the option grant’s risk incentives (after adjusting for option cost). Finally, averaging also improves the value and incentive effects of indexed stock options.     

Six Factors That Explain Executive Pay (and its Problems)

The authors start by showing that six factors—responsibility (i.e., position and company size), industry, pay inflation, business risk, performance and company pay policy—explain over 75% of the variation in the pay of top-five U.S. executives for a sample of 75,000 cases during the years 1997–2008. They also show that the current structure of top-executive pay creates a stronger incentive for revenue growth than for shareholder value growth, and that a 10% increase in shareholder value increases incentive compensation by only 3%. Moreover, their research suggests that the “value incentive” of the average U.S. executive is only one third as strong as the incentive that would be provided by simple “sharing” concepts, such as those provided by plans that give executives a fixed percentage of economic profit or annual grants of a fixed number of shares of stock. The article concludes by reviewing some recent research on incentives and company performance and offering suggestions to help investors identify companies with strong and cost-efficient shareholder value incentives.     

Managerial Risk-Taking Incentives and Executive Stock Option Repricing: A Study of US Casino Executives

I examine the relation between managerial incentives from holdings of company stock and options and stock option repricing. Because options provide incentives to increase both risk and stock price, firms must realize that as options go underwater, executives might face incentives to invest in risky, negative NPV projects. Repricing may alleviate such incentives. I examine repricing activity by firms in the US gaming industry and find that risk-taking incentives from options are positively related to the incidence of executive option repricing. The results support the hypothesis that repricing assists firms in alleviating excessive risk-taking incentives of senior management.     

Investor pricing of CEO equity incentives

The main purpose of this paper is to explore CEO compensation in the form of stock and options. The objective of CEO compensation is to better align CEO-shareholder interests by inducing CEOs to make more optimal (albeit risky) investment decisions. However, recent research suggests that these incentives have a significant down-side (i.e., they motivate executives to manipulate reported earnings and lower information quality). Given the conflict between the positive CEO-shareholder incentive alignment effect and the dysfunctional information quality effect, it is an open empirical question whether CEO equity incentives increase firm value. We examine whether CEO equity incentives are priced in the firm-specific ex ante equity risk premium over the 1992–2007 time period. Our analysis controls for two potential structural changes over this time period. The first is the 1995 Delaware Supreme Court ruling which increased protection from takeovers (and decreased risk) for Delaware incorporated firms. The second is the 2002 Sarbanes–Oxley Act which impacted corporate risk taking, equity incentives, and earnings management. Collectively, our findings suggest that CEO equity incentives, despite being associated with lower information quality, increase firm value through a cost of equity capital channel.     

The Subjective Valuation of Indexed Stock Options and Their Incentive Effects

We analyze the potential role of indexed stock options in future pay‐for‐performance executive compensation contracts. We present a unified framework for index‐linked stock options, discuss their incentive effects, argue that indexation schemes based on the capital‐asset pricing model (CAPM) are the most suitable for executive compensation, and derive a subjective pricing model for the class of CAPM‐based indexed stock options. Contrary to earlier work, executives would not be motivated to take on investment projects with high idiosyncratic risk once their lack of wealth diversification and degree of risk aversion are factored into the analysis.     

Dividend taxes and stock volatility

How do dividend taxes affect stock volatility? If a risk-averse executive faces price risk through his incentive contract, changes in stock volatility due to dividend taxes may increase agency costs and therefore decrease overall welfare. In this paper, I use a decrease in dividend taxes as a natural experiment to identify their effect on the firm’s idiosyncratic stock return volatility. Stock volatility decreased after the tax cut for firms at which executives have larger sensitivity to stock price in their incentive compensation package relative to firms at which executives have a smaller sensitivity. Therefore, with risk-averse executives and risk-neutral shareholders, dividend taxes may exacerbate agency costs. The increase in agency costs will decrease shareholder welfare, which can be partially offset by the use of options in the employment contract.     

期权激励与企业并购行为

本文以2006年至2015年我国上市公司为研究对象,考察了期权激励对企业并购行为的影响。研究发现:授予高管的期权激励显著提升了企业发起并购的可能性和并购规模。缓解代理问题和提升风险承担是潜在的作用渠道。进一步研究表明,激励对象异质性会影响期权激励的效果,期权激励对企业并购倾向和并购规模的提升作用在管理者年龄较高、管理者任期较长以及管理者相对薪酬水平较低的企业中更加明显。此外,期权激励对企业并购行为的影响在非国有企业中更加突出。最后,本文还发现期权激励提升了企业并购的财务业绩。本文的研究不仅丰富了有关期权激励效果方面的文献,而且对于理解企业并购行为具有一定的参考意义。     

Executive stock options and incentive effects due to systematic risk

Existing research on executive stock options mainly focuses on total risk when studying risk incentives. In this study, we use a GARCH option pricing framework to show that the incentive effects of executive stock options depend on the composition of risk. Controlling for total risk, the value of executive stock options increases with systematic risk and this effect is stronger when the total risk is low. Thus, when firms grant standard or non-indexed options, CEOs will have incentives to increase systematic risk even when the total risk remains constant. In contrast, indexed options will provide CEOs with incentives to reduce systematic risk. We therefore conclude that an optimal mix of indexed and non-indexed option grants will provide CEOs with incentives to take the desired level of systematic risk.     

公司社会声望与高管薪酬:公共服务抑或职业声誉

本文基于“隐性—显性”契约激励研究范式,探讨公司社会声望对高管薪酬的影响以及作用机制。本文选取2009—2017年间的非金融A股上市公司为样本,研究发现,拥有较高社会声望的公司,其高管显性薪酬较低。具体而言,公共地位较高的国有企业、具有较高市场声誉的民营上市公司,其高管薪酬平均而言分别比其他上市公司低4.97%和6.30%。进一步地,我们发现公司声望对我国高管显性薪酬契约存在两种作用机制:一方面,公共地位较高的国有企业,可以为高管带来较高的社会声誉和社会认可,满足了“公共服务”类高管的社会声望偏好,从而降低了显性薪酬的支付水平;另一方面,市场声誉较高的民营企业,可以为高管带来较高的职业声誉和未来职业利益,符合“以商为荣”类高管的社会声望偏好,使高管愿意接受较低的显性薪酬。本文的结论为公司声望作为一种有价值的资源,可以对高管显性薪酬形成议价能力提供了重要证据,揭示了公司声望对高管显性契约激励的影响路径;同时,为国有企业高管薪酬契约设计以及激励机制提供了一定启示。     

公司社会声望与高管薪酬:公共服务抑或职业声誉

本文基于"隐性—显性"契约激励研究范式,探讨公司社会声望对高管薪酬的影响以及作用机制。本文选取2009—2017年间的非金融A股上市公司为样本,研究发现,拥有较高社会声望的公司,其高管显性薪酬较低。具体而言,公共地位较高的国有企业、具有较高市场声誉的民营上市公司,其高管薪酬平均而言分别比其他上市公司低4.97%和6.30%。进一步地,我们发现公司声望对我国高管显性薪酬契约存在两种作用机制:一方面,公共地位较高的国有企业,可以为高管带来较高的社会声誉和社会认可,满足了"公共服务"类高管的社会声望偏好,从而降低了显性薪酬的支付水平;另一方面,市场声誉较高的民营企业,可以为高管带来较高的职业声誉和未来职业利益,符合"以商为荣"类高管的社会声望偏好,使高管愿意接受较低的显性薪酬。本文的结论为公司声望作为一种有价值的资源,可以对高管显性薪酬形成议价能力提供了重要证据,揭示了公司声望对高管显性契约激励的影响路径;同时,为国有企业高管薪酬契约设计以及激励机制提供了一定启示。     

Revisiting the incentive effects of executive stock options

We develop a multiperiod framework to evaluate the incentive effects of executive stock options (ESOs). For a given increase in the grant-date firm stock price (and a concurrent increase in return volatility), the increment of total value at the vesting date acts as a proxy for the incentive effects of ESOs. If the option is attached to the existing contract without adjusting cash compensation, we suggest that a firm should not always fix the strike price to the grant-date stock price; instead, the strike price should vary with the length of the vesting period. We also show that, compared with at-the-money options, restricted stock generates greater incentives to increase stock prices in some scenarios, especially when equity-based awards are vested early. If the vesting period is long, the firm could grant options instead of restricted stock to maximize incentives.     

SIX CHALLENGES IN DESIGNING EQUITY-BASED PAY

The past two decades have seen a dramatic increase in the equitybased pay of U.S. corporate executives, an increase that has been driven almost entirely by the explosion of stock option grants. When properly designed, equity‐based pay can raise corporate productivity and shareholder value by helping companies attract, motivate, and retain talented managers. But there are good reasons to question whether the current forms of U.S. equity pay are optimal. In many cases, substantial stock and option payoffs to top executives–particularly those who cashed out much of their holdings near the top of the market–appear to have come at the expense of their shareholders, generating considerable skepticism about not just executive pay practices, but the overall quality of U.S. corporate governance. At the same time, many companies that have experienced sharp stock price declines are now struggling with the problem of retaining employees holding lots of deep‐underwater options. This article discusses the design of equity‐based pay plans that aim to motivate sustainable, or long‐run, value creation. As a first step, the author recommends the use of longer vesting periods and other requirements on executive stock and option holdings, both to limit managers' ability to “time” the market and to reduce their incentives to take shortsighted actions that increase near‐term earnings at the expense of longer‐term cash flow. Besides requiring “more permanent” holdings, the author also proposes a change in how stock options are issued. In place of popular “fixed value” plans that adjust the number of options awarded each year to reflect changes in the share price (and that effectively reward management for poor performance by granting more options when the price falls, and fewer when it rises), the author recommends the use of “fixed number” plans that avoid this unintended distortion of incentives. As the author also notes, there is considerable confusion about the real economic cost of options relative to stock. Part of the confusion stems, of course, from current GAAP accounting, which allows companies to report the issuance of at‐the‐money options as costless and so creates a bias against stock and other forms of compensation. But, coming on top of the “opportunity cost” of executive stock options to the company's shareholders, there is another, potentially significant cost of options (and, to a lesser extent, stock) that arises from the propensity of executives and employees to place a lower value on company stock and options than well‐diversified outside investors. The author's conclusion is that grants of (slow‐vesting) stock are likely to have at least three significant advantages over employee stock options:

• ? they are more highly valued by executives and employees (per dollar of cost to shareholders);
• ? they continue to provide reasonably strong ownership incentives and retention power, regardless of whether the stock price rises or falls, because they don't go underwater; and
• ? the value of such grants is much more transparent to stockholders, employees, and the press.

     

Risk-taking incentives of executive stock options and the asset substitution problem

Various theoretical models show that managerial compensation schemes can reduce the distortionary effects of financial leverage. There is mixed evidence as to whether highly levered firms offer less stock‐based compensation, a common prediction of such models. Both the theoretical and empirical research, however, have overlooked the leverage provided by executive stock options. In principle, adjusting the exercise prices of executive stock options can mitigate the risk incentive effects of financial leverage. We show that the near‐universal practice of setting option exercise prices near the prevailing stock price at the date of grant effectively undoes most of the effects of financial leverage. In a large cross‐sectional sample of Canadian option‐granting firms, we find evidence that executives' incentives to take equity risk are negatively rather than positively related to the leverage of their employers.     

CEO compensation, option incentives, and information disclosure

This paper examines the impact of information disclosure on the valuation of CEO options and the incentives created by those options. Prior executive compensation research in the US has made assumptions about key input variables that can affect the calculation of option values and financial incentives. Accordingly, biases may have ensued due to incomplete information disclosure about noncurrent option grants. Using new data on a sample of UK CEOs, we value executive option holdings and incentives for the first time and estimate the levels of distortion created by the less than complete US-style disclosure requirements. We also investigate the levels of distortion in the UK for the minority of companies that choose to reveal only partial information. Our results suggest that there have to date been few economic biases arising from less than complete information disclosure. Furthermore, we demonstrate that researchers using US data, who made reasonable assumptions about the inputs of noncurrent option grants, are unlikely to have made significant errors when calculating CEO financial incentives or option wealth. However, the recent downturn in the US stock market could result in the same assumptions, producing exaggerated incentive estimates in the future.     

Is U.S. CEO Compensation Broken?

This article addresses four major concerns about the pay of U.S. CEOs: (1) failure to pay for performance; (2) excessive levels of pay; (3) failure to index options and other equity-based pay, resulting in windfalls; and (4) too much unwinding of incentives. The authors' main message is that most if not all of these concerns are exaggerated by the popular tendency to focus on the annual income of CEOs (consisting of salary, bonus, and stock and option grants) while ignoring their existing holdings of company equity.
Taking into account the effect of stock price changes on CEO wealth leads the authors to a number of interesting conclusions. First, the pay-for-performance relationship is strong and has grown significantly in recent years. Second, what may appear as above-normal growth in annual pay levels may be necessary to compensate CEOs for the increased risk associated with their growing level of equity-based incentives. Third, conventional (that is, unindexed) stock and options, when viewed as a combination of market risk and firm-specific risk, may provide an optimal solution to two conflicting demands: shareholders' demand for executive rewards tied to company performance and executives' preference to diversify their wealth. Finally, there is little evidence of widespread CEO unwinding of incentives, and levels of CEO equity ownership in the U.S. remain impressively high.     

Executive Stock Options

Abstract

As a part of the compensation package many companies provide executives with executive stock options, which are call options with additional restrictions. They provide some financial advantages to the executives and help the company retain the service of the executives who improve the company’s earnings and management.

Until recently the values of the executive stock options were not required to be disclosed in the company?s financial reports. But recent statements from the Financial Accounting Standards Board (FASB) have made it necessary to value these executive stock options. The valuation of executive stock options is also required for investors and financial practitioners. This paper considers the award of performance-based executive stock options when the stock price at the time of stock option award exceeds a given preassigned value. It is assumed that the stock price follows a geometric Brownian motion, and that the number of stock options awarded at any time depends on the stock price at that time.

A valuation formula is derived using the method of Esscher transforms for a multiyear award plan. The closed-form formula derived is similar to the Black-Scholes formula for options and utilizes the standard bivariate normal distribution function, which is available in statistical software. In this paper the number of stock options awarded is assumed to be in a specific form, but the theory presented can be modified to suit other forms of award structure. Moreover, by suitable choice of parameters, a valuation formula is also presented for the award of fixed-value executive stock options grants; this formula is also in a closed form and involves cumulative distribution values of the standard normal random variable. Numerical illustrations of the use of the valuation formulas are presented.     

Valuing executive stock options: performance hurdles, early exercise and stochastic volatility

Accounting standards require companies to assess the fair value of any stock options granted to executives and employees. We develop a model for accurately valuing executive and employee stock options, focusing on performance hurdles, early exercise and uncertain volatility. We apply the model in two case studies and show that properly computed fair values can be significantly lower than traditional Black–Scholes values. We then explore the implications for pay-for-performance sensitivity and the design of effective share-based incentive schemes. We find that performance hurdles can require a much greater fraction of total compensation to be a fixed salary, if pre-existing incentive levels are to be maintained.     

IRC Section 162(m) and the law of unintended consequences

In 1993, Section 162(m) of the U.S. Internal Revenue Code was passed into law with the intent to reign in outsized executive compensation by eliminating the tax-deductibility of executive compensation above $1 million unless the excess compensation was performance-based. An unintended consequence of the legislation was that executives' total compensation actually increased in the post-1993 period, largely due to a dramatic increase in employee stock options. Employee stock options have unintended consequences of their own. The economic value of stock options may be influenced by executive decision-making when the options are valued using the Black-Scholes model or some variant thereof. Our findings suggests an unintended consequence that executives used their discretion to positively impact the performance-based component of their compensation through actions increasing share price volatility and reducing dividend yields, assumptions implicit in option valuation models.     

Top Management Incentives and Corporate Performance

There is little agreement about either the effect of executive compensation on corporate performance or the best way to measure the strength of executive incentives. With little guidance from academic research, managers and directors continue to rely heavily on the percentage of pay "at risk" as a proxy for incentive strength.
Starting with the premise that managers, like investors, are motivated by prospective changes in their wealth, this article presents a measure of incentive strength called "wealth leverage" that reflects the sensitivity of an executive's company-related wealth—total stock and option holdings plus the present value of expected future compensation, including future salary, bonus and stock compensation—to changes in shareholder wealth. After estimating top management's wealth leverage at 702 companies, the authors conclude that: 1) the median company has significant wealth leverage; 2) almost all corporate wealth leverage comes from their accumulated stock and option holdings, not from current compensation; and 3) companies with higher wealth leverage significantly outperform their industry competitors.